BACKGROUND: Although Georgia’s \"Rose Revolution\" occurred only three years ago, in November 2003, many positive results are already visible, especially as concern foreign investment and the overall perception of the country among multinational policymaking bodies. The new government has made concrete progress towards meeting international standards not only in terms of political governance, such as in its anti-crime and -corruption drive, but in terms of economic modernization. For example, over these three years, the government has cut red tape for businesses, overhauled the tax code and abolished most customs duties. These measures have encouraged many businesses out of the shadows and into the formal economy, resulting in significant rises in government revenue and helping to reduce the budget deficit to a manageable level. The macroeconomic picture is now quite favorable, characterized by good fiscal performance, a stable currency, growing consumer spending together with low levels of personal debt, massive government investment in infrastructure, and a notable increase in activity by foreign investors. This progress has been noted by such institutions as the EBRD and the World Bank, which recently cited Georgia as having achieved the largest reduction in corruption among all “transition” countries from 2002 to 2005. While Georgia’s GDP growth is quite high, averaging 8 percent over this period, this is coming from a very low level. Growth has mainly been in construction, food processing, transportation and tourism, and much still has to be done to stimulate foreign direct investment as well as encourage small and medium-sized business activity. A key component of Tbilisi’s economic policy has been its push for the creation of an energy and transportation corridor, independent of Russian control, to bring oil and gas from Azerbaijan and to a lesser extent from Central Asia, through Georgia to markets in Turkey and Europe. This policy has developed in concert with the growth of U.S.-Georgia bilateral relations, highlighted by President Bush’s visit to Tbilisi in 2005. Russia has looked askance at these developments; it supports the de facto governments of Georgia’s breakaway regions Abkhazia and South Ossetia, which contain many thousands of ethnic Russians, and strongly opposes Georgia’s close relations with NATO. Moscow gave its grievances concrete form by taking a number of actions which can easily be interpreted as having strong political overtones, designed to pressure Tbilisi to review its policies. In the second quarter of 2006, Russia instituted embargoes on Georgian wine and mineral water, the major Georgian exports to Russia; these were followed by the severing of transportation links, the closing of several Georgian-owned businesses in Moscow and the deportation from Russia of a number of ethnic Georgians. The culmination was the widely reported announcement that Russia’s gas monopoly Gazprom intends to raise Georgia’s tariff of USD110 per 1,000 cubic meters of gas to USD230 starting in 2007. Although Gazprom has indicated to several other CIS countries such as Armenia and Belarus that it intends to raise subsidized rates to bring them in line with market prices, Tbilisi interpreted the announcement as a political one and rejected Gazprom’s offer to maintain the current price if Georgia agrees to give Gazprom control of its gas distribution network.

IMPLICATIONS: While Moscow’s recent actions vis-à-vis Tbilisi have raised serious concerns among Georgians and international observers alike, a closer look at Georgia’s current economic situation indicates that the deleterious effect of Russia’s actions is not so clear-cut. For example, Georgians working abroad make up around 20-30% of Georgia’s total labor force and their remittances account for nearly 6-7% of Georgian GDP, and the nearly 500,000 labor migrants of Georgian ethnicity in Russia account for around two-thirds of total net remittances to Georgia. However, no mass expulsion of Georgians from Russian territory has yet occurred. In fact, both Georgian and Russian media have estimated that the number of ethnic Georgians deported from Russia since the beginning of October 2006 is only around 4,000. Nor does there appear to be a noticeable decrease in the level of remittances during November: a major Georgian bank has forecast net annual transfers for 2006 at US$556 million; up 14 percent year-on-year. Furthermore, Russia’s reported intention to cut money transfers from Russia to Georgia, even if factual, is largely unenforceable for several reasons: Georgian officials have charged that restricting money transfers violates International Monetary Fund regulations; transfers are often made through non-Russian companies such as Western Union; and Georgians in Russia might be driven to bypass such regulations anyway by wiring money through other states such as Armenia or Ukraine. While it is true that wine producers were hit hard by Russian sanctions (in 2005 Russia accounted for up to 80 percent of Georgia’s wine exports), Georgia’s export structure, both by goods and by region, is quite diversified already and businesses are actively seeking alternative markets for their export products. The more immediate cause for alarm is, of course, the potential effect of a gas price hike by Gazprom. However it must be noted that during 2006 the price already increased from US$65 to US$110 per 1,000 cubic meters, for an estimated annual impact on the current account of around US$85m, or just 1.1 percent of GDP. As total gas imports in 2005 amounted to around US$91m, even a doubling of rates would not much hurt the current account balance. Observers note that gas prices above US$200 might push Georgia to buy its gas from Iran and Azerbaijan rather than Russia, effectively ending its dependence on Gazprom. The Georgian government has also announced that it intends to soften the effects of a sudden increase in gas prices for low-income families through direct subsidies, a not very difficult task given the government’s strong fiscal profile.

CONCLUSIONS: Abroad, the resolute maneuvering of Georgia’s President Saakashvili is keeping the country in the news; he has had some success in presenting his nation as the victim in its dispute with Russia. Inside Georgia, Moscow’s antagonistic stance has served to increase support for Mr. Saakashvili, reflected in the ruling party’s victories in local elections in October. Now that oil and gas pipelines are crisscrossing Georgia, the country has a newfound international significance that its authorities are doing their best to exploit. Georgia will need great skill to avoid overplaying its hand with Russia. Russia’s energy exports windfall has only emboldened its foreign policy and endowed it with numerous bargaining chips, particularly as relate to furthering its influence among its immediate neighbors. In the ongoing feud between Moscow and Tbilisi, the leverage of Georgia’s American ally is limited because the latter seeks Russia’s cooperation in larger foreign policy concerns. Unfortunately, the lack of a strong independent energy policy in the U.S. means that in its foreign affairs it is peculiarly beholden to countries which are large producers and exporters of oil. For instance, Russia may choose to use America’s support for Georgia as a bargaining chip in exchange for supporting U.S. policy on such pressing issues as Iran’s nuclear program. However, it is equally true that Russia’s efforts to rein in Georgia may backfire. If Russian actions push Georgia to successfully find new sources for its imports and new markets for its exports, it will likely end up even farther away from the Russian sphere.

AUTHOR’S BIO: Peter G. Laurens is Associate Director of a U.S.-based fixed income hedge fund.